Is there a relationship between these two seemingly unrelated things? We think so. OK, what is this dollar cost averaging? For short, we'll call it DCA from now on.
You might have heard that DCA is a way to increase your returns as opposed to what we call "dumping the lump" into the markets. Actually it's not that at all. What it is, my friends, is a way to REDUCE risk!! It requires the discipline to put regular amounts of money into the markets on a regular schedule without regard to where the market, the stock, the mutual fund, or whatever, is at the time you make the investment. As the market fluctuates, up and down, like a roller coaster, you are buying and accumulating shares. As prices go up, you buy less and as prices go down, you buy more with the same dollars. Your average cost, as time goes by, will ALWAYS be less than the average price you paid for each purchase.
Here's how it works with some numbers. We have $30,000 to invest on January 1. We "dump the lump" in at $5,000 per share and buy 6 shares. At the end of June, we still have 6 shares worth $30,000. During this six months we might have been losing some sleep watching the roller coaster. Or, we could have invested $5,000 per month as shown here.
Month Share Dollars Shares U Buy Price Invested Bought
We bought 17 shares at an average cost of $1,764. $30,000 divided by the 17 shares.
The average price of the trades is $2,667. $5,000+2,000+1,000+2,000+1,000+5,000 = $16,000 divided by 6. This is higher because we bought more shares when the price was down and less when it was up!
Our shares are worth $35,000 at the end of the period.
We slept better through all this because we knew that NO MATTER WHAT we are in for the long term and these swings are just what we really want and need.
Want to make it easy to adhere to the discipline of regular investing? Just about every mutual fund and many companies with dividend reinvestment plans (see our page on this subject) will let you sign up for automatic investment plans. You tell them how much you want to invest each month or quarter and they will take the money out of your bank account and invest it for you. We really believe in this approach. We use it in all the individual stocks we own and the mutual funds. This plan is perfect for the investor who doesn't have that big lump to start with, but can invest small amounts regularly. May your roller coaster ride be fun AND profitable!!
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